Contributing Firms:
A report from Morningstar says 23% of funds labelled Article 8 (light green) under the Sustainable Finance Disclosure Regulation (SFDR) do not meet Morningstar’s criteria of an ESG fund, highlighting the differing interpretations of ESG standards and metrics currently in asset management. What are your views on these differing interpretations?

Frank Talsma, Director, Risk & Investment Analytics at RBC Investor & Treasury Services:
Frank Talsma
Frank Talsma
In particular greenwashing continues to be a burning topic as regulators worldwide are cracking down on cases of alleged misleading ESG claims. Consequently, the fund industry increasingly realizes that there is significant reputational risk involved, leading some firms to reconsider their ESG choices and what they report on. For example, including scope 3 emissions for carbon footprint often gives a very different picture than reporting on scope 1 and 2 emissions alone.

There are a multitude of such data & reporting inconsistencies that make it hard to compare companies and products on an equal basis, which in turn gives rise to misunderstandings/misinterpretations.

Against this backdrop, we observe a rise of anti-ESG, in particular the US market, where certain states have prohibited their pension plans to invest in ESG funds as they would shun their oil and gas industry. In the meantime in the EU, we are seeing some article 9 funds demoting back to article 8. However, at the same time, an unprecedented amount of institutional money is looking to invest in ESG. The key is therefore to restore confidence in ESG products to satisfy the demand and continue the exceptional growth trajectory.

In your view, what are the major ESG difficulties facing promoters of European funds? Ahead of the implementation of further SFDR requirements in 2023, what steps might fund promoters take now?

Andrea McEvoy, Associate Director, ESG Research, IQ EQ Fund Management (Ireland) Limited: With the advance of the Sustainable Finance Disclosure Regulation (SFDR), European funds are operating in a more stringent regulatory environment than their overseas peers. The underlying objective of SFDR is to introduce consistency and improve fund level sustainability disclosures and classifications, particularly for funds which are marketed as ‘ESG’ oriented. Theoretically, this should lead to greater transparency and reduce unsubstantiated claims of sustainability or ‘greenwashing’.
Andrea McEvoy
Andrea McEvoy

Over the long-term, we believe SFDR will revolutionise sustainable reporting and corporate level disclosures which may give European funds a relative advantage if such transparency is rewarded with fund flows.

In the interim, and from an asset manager’s perspective, the ‘building blocks’ of corporate data disclosure are not yet mature enough to support the regulation’s requirements placed at a fund level. It’s estimated that globally only 2% of small-cap companies and 20% of large-cap companies are reporting more than 70% of SFDR Principle Adverse Impacts (PAIs) indicators, out of a sample size of circa 29,0003 companies. There is a strong bias to European companies, with only 3% of those in the US and 1% in APAC reaching this hurdle. The rigour, consistency and coverage of non-financial ESG data reported by corporates is far from the standard of financial data.

Improving disclosure is a core objective of the Corporate Sustainability Reporting Directive but this piece of legislation will only come into play for European corporates from 2025. Furthermore, corporate disclosures under the EU Taxonomy, a classification system for sustainability activities also encouraged by SFDR, are also limited at this point.

So, how can asset managers bridge this gap when faced with the 2023 deadline to meet increasing SFDR fund level disclosures? It’s important to recognise that the pace of regulatory requirements does not appear to be stalling in the pursuit of data perfection. All asset managers are operating in an equally uncomfortable state. They also have a responsibility to be able to support sustainability fund level disclosures with underlying evidence. Against this backdrop, good practice would be to clearly outline ESG processes and understand the data – and its limits – that can be provided to investors, as required. Such caveats will be familiar across the industry but should hopefully reduce in time as data quality improves.

Frank Talsma, Director, Risk & Investment Analytics at RBC Investor & Treasury Services: There is very little time left to address all these challenges until SFDR Level II becomes effective in January 2023. The key thing now is for firms to get their product definitions and disclosures in order. Data will not be perfect and there will be gaps in reports such as the EET, but firms will need to clearly label their funds and define their products strategies in relation to ESG, preferably in plain unambiguous language supported by the best and most appropriate data currently available.